What Will Happen in a US Debt Default or Credit Crisis

Sadly, I see no way that the US will not eventually default on its debt. There was a chance a few years ago when Ted Cruz and a few other staunch fiscal conservatives shut the government down in an effort to hold the debt ceiling and get a sustainable budget, but those hopes vanished when he was forced to cave. After that episode where the government was shut down for a couple of weeks, Congress has just given the President all that he wanted and automatically kicked the can down the road past the next election or fiscal year. As a result, our debt has climbed to above $20 T and we’re paying about $459 B in interest each year (latest figure for 2017).

It is possible for the US to change its ways and pay off the debt, but we would need to change the people in Congress. The people in Congress, in turn, are a reflection of voters in the US. While there are a few of us out here writing our Congressman and telling him/her to balance the budget and stop spending so much, there are a lot of others who are demanding that programs be expanded and oppose any sort of cut. While Congress is a problem, the real problem is the American voter who is perfectly happy to see the government pile up debt, or is at least ignorant to the issue. I’m doubtful that will change without a crisis, which is why I expect a default.

So, how far is the US from a default? The US is currently bringing in about $3.32 T in income, which is equal to $3320 B. This means that interest payments are only about 13% of our income, which is significant but manageable. If we were to stop increasing the debt, with time the percentage of income paid out for interest would decline and the debt would become more manageable each year. The issue is that we keep adding to the debt. For 2017, we spent about $3.98 T, so we had a deficit of $665 B. This is a lot better than the trillion-dollar-plus deficits we saw during several years between 2008 and 2016, but as the deficit grows, the interest payment also grows, and it will eventually become unbearable. Interest rates will also probably rise as the debt grows and default becomes more likely. On our current trajectory, a crisis could emerge in ten to twenty years.

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And that is the real issue to fear, at least immediately: Increases in interest rates.

Unlike a wise homeowner who locks in a rate for the life of the loan, the US Federal Government goes out to the markets and resets interest rates regularly. In the past, since US Government Debt was the safest investment out there, the interest rates paid were very low, on the order of 3% or less. That could change very quickly, however, if people became concerned about the government paying its debt.

If interest rates doubled or tripled from their current rates, we’d be seeing a quarter to a third of government income being swallowed up by interest payments, which would either cause the debt to rise much faster or the need to cut spending drastically. This could happen very quickly, leading to a crisis within the next few years. This is why the time is now to start thinking about what the results of a credit crisis or even a default would be for citizens of the United States and to start doing things to protect yourself and your family. So what would happen?

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1. Credit would disappear, or become very expensive.

Think about what would happen if you just stopped paying your credit card payments, your home loan mortgage, and your car payments. It would be very difficult to take out any other loans or get any new credit cards. If anyone did lend to you, they would charge you high interest rates and expect a lot of collateral since they, justifiably, would be worried that you would stiff them as well. A lot of the debt the US government has comes from US citizens buying savings bonds and treasury bills as a safe place to put their money. This market would dry up instantly if the government stopped paying its bills.

2. The US Government would instantly need to live within its means.

This effect is kind of a good thing. The government would need to do the hard task of cutting back to live within the revenue it generates, which would be much healthier going forward, but cause a lot of pain right away. They could (and probably would) try to raise revenues by raising taxes, but it is unlikely that this would be effective since raising taxes generally causes people to produce less and often actually causes government revenues to decrease. This means the government would need to pick and choose what to fund and what to cut.

3. Critical items could be covered.

Hopefully Congress would put essential functions such as national defense first. Currently, the US spends about $870 B on defense, which is only about 25% of revenues. Defense could also stand to see a cut, since there is a lot of waste, or at least a redirection of funds from wasteful activities to more critical activities. If waste could be eliminated, spending on defense could be cut a bit as well.

4. Entitlements would need to be cut.

The government spends $1212 B on Medicaid and welfare plus $1400 B on Social Security and Medicare payments. Combine that with the $870 B spent on national defense and you have a bill of $3.5 T before you even add things like roads, parks, and government pensions. We are therefore spending more than we’re bringing in on these items alone. If we could not borrow money, entitlements would need to be cut. We could see some cuts to welfare, but that would bring a huge outcry. Expect instead to see programs like Social Security and Medicare benefits start to phase out for wealthier citizens. There is nothing fair about this, but in a crisis the large number of people who don’t save and invest would team up against the smaller number who do. Also expect people who are physically able to take care of themselves to be expected to do so, so welfare would be harder to get.

5. A lot of people in “safe” investments would be hurt.

Probably the worst effect would be that on creditors to the US government, which includes a lot of retirees and near-retirees who hold a lot of US Government bonds, thinking they are secure. That whole portion of their portfolio could be wiped out, taking the interest payments they were using for expenses along with it. This would make the need for Social Security and Medicare payments even more critical, just at the time they were being cut. Expect to therefore see a lot of impoverished seniors who would be dumped on the welfare rolls and need help from adult children and friends.

In the next post, we’ll talk about what you need to do to be ready.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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